All businesses need a way to measure the success of their various investments, strategies and decisions. This is done by capturing the return from any investment: the additional profits and value the investment has been able to bring to the company. The most reasonable way to look at the success of previous investments and to compare the potential of future investments is to calculate a rate of return for these types of projects.
The rate of return can also be called the return on investment (ROI) or internal rate of return (IRR). These names can mean slightly different things. As a concept, rates of return are calculated by comparing the current value of the investment with the initial cost of the investment, given as a percentage of the initial cost. The rate of return formula is as follows:
[ (Current Value - Cost) / Cost ] x 100 = %RR
Calculating the current value of the investment includes any income received resulting from the investment as well as any capital gains that have been realized. The rate of return is usually calculated using value created over a period of time, thus representing the net gain or loss over that time period. It’s comparing two snapshots of value: the cost of the capital and the gains it has provided.
This can be a critical part of the analysis. For example, a high rate of return means something different over two years than it does over 20 years.
The rate of return can be used to judge the success of a project. Obviously, a higher rate of return is desirable, whereas a negative rate of return represents a net loss on the investment within that specific time period.
As rate of return is usually calculated at the end of an investment’s useful life, rates of different investments can be compared with each other. This information can be used to drive future investments by revealing which types of investment provide net gain and which are unsuccessful. A higher ROI represents a better return on the investment, but it should be taken into consideration that ROI looks at a time period without making many adjustments for the change in the value of money over time.
To understand this ERR economics concept, consider investing in the general sense (rather than specifics like capital projects, stocks or bonds). Having $100 today is worth more than having $100 in five years, namely because that $100 could be invested somewhere and collect interest, meaning that in five years it will in fact be worth more than $100. This assumes a generic interest rate is available for that $100 to be invested, which is often an industry standard.
Consider a company that invests $100 into three different projects. Each project ends up being worth $300 at the end of its life, meaning each project would have the same ROI. However, if project X returned $300 in two years, project Y returned $300 in five years and project Z returned $300 in 10 years, then that’s a significant difference in project performance that isn’t necessarily captured in the ROI. This is why businesses use the internal rate of return as well.
Rate of return and return on investment are often used interchangeably; internal rate of return, or IRR, is a measure often used to gauge the attractiveness of future investments. IRR is designed to capture the rate where the net present value of the positive (profits, etc.) and negative (costs, etc.) cash flows reach zero. This calculation involves a discount rate, which is a tool investors use to judge how the value of money changes over time due to inflation and other factors. This discount rate represents the minimum rate of return that’s acceptable to the investor; most companies set a minimum discount rate, and the calculated IRR is compared to this discount rate to determine the attractiveness of the project.
The calculation of the IRR involves many iterations, so it’s best to use a tool like Excel to obtain this value. The concept involves calculating over a number of time periods (for example, years) the discount rate at which the profits and losses during that time period — discounted for the future value of that time period — net to zero. This sounds confusing, so consider IRR as a number whose value is most important in comparison to other ones.
If a project has an IRR of 20% and other investments the company can make are only expected to yield 5% over the same time period, then that investment project looks favorable as opposed to the alternatives. The higher the IRR, the more potential that project has to be a good company investment as compared to other investments. This can help a company choose its types of investment strategies.
With this in mind, the difference in IRR and ROI is that ROI looks at two snapshots and does not account for the change in the value of money over time, while IRR offers an understanding of a comparable “interest rate” the investment may pay back.
IRR may seem more representative, but ROI is easily calculated and offers a straightforward capture of the value produced by the investment. IRR can be difficult to calculate, although most software like Excel offers ways to solve the iteration sum formula for the IRR.
The standard rate of return or return on investment calculations can be used to evaluate previous investments which may have reached the end of their useful life. This lets management know which investments were worthwhile and gives them a starting point from which they can develop an understanding of why some investments work out and others don’t.
The rate of return can also be used to compare potential future projects, which will require estimation of the project’s lifespan, revenues to be gained over this set timeline and the potential cost of the project in capital. This is one of the values often used when management creates the capital budget for a company.
The internal rate of return is usually used against some benchmark determined by company executives as a minimum desired discount rate. Since IRR looks at the decreasing value of money over time, IRR can capture comparisons that won’t appear in ROI.
A company is considering two potential investments, A and B. They may have similar returns on investment, but if A is a five-year project and B is a 10-year project, that same ROI now means two different things if you take into consideration the way the value of money changes over time. Companies that are on accelerated timetables may even require projects to break even in periods of two to three years. These analyses look at both ROI and IRR.
Companies use these values in two different ways: to evaluate previous investments and to make decisions about future ones. It’s easier to calculate ROI and IRR for projects that have already been completed, of course, than it is to make estimations in the future. Project managers and accounting analysts can sift through the project’s costs and its revenue streams over time and provide this kind of information to management.
This is usually done at project close, but often, a company will look at investments over the last five to 10 years to evaluate which sorts of projects were the most successful. The information gained from this type of analysis becomes a part of the next step, which is making investment decisions to establish a capital budget projection for the company’s future.
Normally, a company will have a desired value for both ROI and IRR, and the departments tasked with estimating capital costs and future returns will compare their projections to the targets in question. Investments with tangible products — new equipment, facilities, production units, improvements and so on — are often the responsibility of an engineering department that can use industry standards and best practices to estimate initial costs, ongoing costs and potential revenues.
Investments with intangible products — marketing campaigns, trainings and so on —often fall within the purview of accounting, marketing and/or sales. These departments have their own tools that can help predict future revenues as well as direct costs. The decision to invest capital in stock, bonds or other financial investments is one that is made at the executive board level.
These values are then used to determine where to spend limited capital. It’s rare that a company has enough capital to invest in every single potential project on its list. Therefore, these values are part of the decision-making process. Keep in mind that there are other factors to consider when looking at potential investments.
For example, some capital projects are unavoidable — replacing old equipment or investing in new software — no matter what the ROI or IRR might be. The managers of the capital budget should be able to consider these factors to make sure that the overall rate of return stays positive.
Likewise, a project with an incredibly high IRR might come with too high of a price tag for the board of directors to approve. There are limitations in every company’s resource pool.
There can also be benefits of investments that can’t necessarily be seen in cash. For example, a targeted marketing campaign may also help the company’s brand image and perception within its marketplace, which may not translate into a dollar figure but still represents intangible value to the company. Likewise, investments in research and development often don’t directly affect the company’s bottom line — they may, in fact, increase costs — but the value of research and development is difficult to capture directly.
Those types of investments may appear to have a poor rate of return but offer opportunities for the research and development team to explore new areas, which may lead to new product lines or additional improvements in the future. Another example is investment in intangible efficiency creators, like online software suites or data management programs. These types of services can improve record retention and data analysis, none of which has a direct impact financially but definitely has value within the company.
All of these factors then become a part of the decision-making process for a business. However, since a company is often driven by its financial success, values like ROI and IRR are usually significant. For any investor, it’s important to understand how these numbers are calculated so that good financial choices can be made. A business’s future is decided by the way investments are made in the past and present. It’s critical to consider the rates of return as a big portion of the decision-making process.